Understanding Macroeconomic Balances: Production, Prices, and Employment
Economic Reality of a Country
External Market Perturbations
Government Economic Policies
Internal Market Forces
The economic behavior of a country is expressed through the free play of supply and demand, reflected in the aggregate supply and demand curves. These curves represent the combined supply and demand of all economic agents (domestic and foreign) operating within the country.
Supply and demand interact and influence three critical economic variables: production, prices, and employment.
Average Level of Prices
This refers to the weighted average prices of all goods and services in an economy.
Aggregate Demand (AD)
AD represents the total expenditure that economic agents (national or foreign) are willing to make within the country. It includes:
- Private Consumption (C)
- Business Investment (I)
- Public Expenditure (G)
- Net Exports (X-M)
AD = C + I + G + (X-M), which is equivalent to GDP.
Difference Between GDP and AD
AD represents the value of goods and services that agents are willing to buy, while GDP represents the value of what is actually purchased. AD reflects spending expectations, while GDP reflects actual spending.
Aggregate Demand Curve (ADC)
The ADC shows the different quantities of products that economic agents are willing to buy at each average price level. Demand increases as prices decrease, and vice versa.
Aggregate Supply (AS)
AS represents the quantity of production that companies are willing to sell at a given average price level and production costs. Influential factors include:
- Average Price Level: Lower prices lead to lower profits, and vice versa.
- Production Costs: Profits are the difference between income and expenses. Rising production costs decrease profits.
- Business Expectations: Market expectations influence the quantity of units offered by companies.
Aggregate Supply Curve (ASC)
The ASC shows the different quantities of production that economic agents are willing to sell at each average price level. Supply increases with prices, and vice versa.
Macroeconomic Equilibrium
Equilibrium is achieved when the plans of buyers and businesses match, i.e., where the AD and AS curves intersect.
Consumption
Consumption drives AD, which in turn influences company supply. Private consumption includes durable goods, perishable goods, and services.
Factors influencing consumption include:
- Disposable Income: Higher disposable income leads to higher consumption.
- Permanent Income: The perceived level of income after removing temporary influences.
- Life-Cycle Hypothesis: Individuals save to maintain a consistent level of consumption throughout their lives.
- Wealth Effect: Wealth influences consumption levels.
Business Investment
Investment and consumption are the most important components of AD. Investment is the purchase of goods that indirectly satisfy human needs by contributing to future production.
Investment serves two functions:
- Increases Demand: Companies acquire assets or capital from other companies, impacting employment and production.
- Increases Production Capacity: Accumulation of capital goods promotes long-term economic growth.
Categories of investment include:
- Investment in Plant and Equipment
- Construction
- Inventory Changes
Factors Affecting Investment
- Revenue: Higher revenue encourages investment.
- Costs: Interest rates and taxes influence investment decisions.
- Productive Capacity: The ability of a company to meet market demands.
- Future Prospects: Confidence in the future is crucial for investment decisions.
Investment has a multiplier effect on production.
Marginal Propensity to Consume (MPC)
MPC is the proportion of additional income that is spent on consumption. A higher MPC amplifies the effects of investment on the economy.
Investment Multiplier
The increase in total expenditure resulting from an increase in investment. Increased spending = Initial Investment * [1 / (1-MPC)]
Personal Savings
Savings are the portion of income not consumed. Savings enable business investment. Investment requires prior savings.
Marginal Propensity to Save (MPS)
MPS is the proportion of additional income that is saved. Total Income = Consumption + Savings
MPC = (Change in Consumption / Change in Income) * 100
MPS = (Change in Savings / Change in Income) * 100
MPC + MPS = 1